Risk aversion returns amid emerging market rout

A sharp sell off in key emerging markets started early in the week when weaker-then-expected Chinese PMI numbers were released, and gathered speed later when Argentina announced that it would stop defending the peso for now. The risk-off trade returned with a vengeance, as equities, credit and commodities all sold off. In currencies, the dollar rallied against most currencies with the exception of the Yen, and, somewhat surprisingly, European currencies, which were buoyed by positive economic surprises in the Eurozone and the UK. All eyes shift now to this week’s Fed meeting, which will shed light on whether the “taper” remains on course in spite of the poor December employment data out of the US and recent financial market wobbles.

GBP

Last week delivered major macroeconomic and policy news for Sterling. Unemployment showed another sharp drop of 0.3%, to 7.1% and just barely above the 7.0% Bank of England threshold for considering tightening monetary policy. However, the BoE minutes for the January meeting (written of course before the unemployment information was available) contained no hint that the MPC is considering bringing forward the timetable for policy tightening. Further, Governor Carney reacted immediately to the unemployment news by strongly hinting in a TV interview that the Committee is considering dropping the threshold guidance framework altogether. Therefore, it seems clear that the BoE will not be easily rushed into raising rates by upside economic surprises. Sterling reacted to these mixed news by rising against the dollar but dropping moderately against a resurgent Euro, while rising sharply against emerging market currencies everywhere.

EUR

There were also strong macroeconomic news from the Eurozone last week. The services business confidence PMI survey rose a full point to 53.2, which is consistent with growth around the 1% mark. This has been traditionally the best leading indicator of GDP growth in the Eurozone, although the correlation as weakened lately. The improvement followed the recent pattern, with Germany strongest above 55, peripheral countries slightly above the 50 mark, and French numbers around 48 still indicating contraction in the Eurozone’s second largest economy. The Euro was the star currency of the week, rising against every major currency worldwide and up very sharply against mots emerging market currencies. The strength of the Euro is likely to impact the Zone’s ability to continue growing through net exports and therefore makes it more dependent then ever on resurgent internal demand.

USD

In contrast to the other major currency zones, there were no major macroeconomic releases or policy news last week out of the United States. Some second-tier data points on the housing market were generally consistent with our view that growth for the last quarter of 2013 (to be published next week) will come in somewhere in the 3-3.5% range. All eyes shift now to the FOMC meeting next week. We think that the Federal Reserve will look past the weak December employment report and recent market sell offs and announce another reduction of $10 billion in the monthly total purchases of Treasuries and mortgages. This should be enough to assure markets that the Fed’s threshold for changing course is fairly high, and therefore should provide further support for the dollar.